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Feb 15, 2021, 3:30 PM GMT

The Intricacies of Limit Orders

Trading is like fishing - it's about being patient

Limit orders represent a more sophisticated version of market orders; however, they require more ‘vision’ from the trader and anticipation of future price swings. Market orders struggle under specific circumstances, such as low liquidity and high volatility. That is why market orders are not especially well-fitted to function under such conditions, which can lead to slippage - the order being executed at a different price than the initially desired one.

For that reason, limit orders can be used ahead of time to ward off this threat of discrepancies in the price, as they guarantee order execution at a specific price level that has been selected in advance. While the benefit of using limit orders is precision of order execution, their drawback is that they may not be filled at all if the price does not reach the specified level. To understand how limit orders are structured, consider the following scenario:

A trader is presently observing the recent developments in the price action of a given asset, and he notices that its current market price is $35 (point A below):

An Example of Long Limit Order

The trader's general expectation is for the price to appreciate, but he also braces for a possible drop to $30 before it finally starts to pick up. For that reason, he can place a long limit order to be executed at $30 (at point C), even if the current price is higher. If that happens, then the trader will make a profit when the price starts to rise.

A long limit order entails the execution of a buy position at a price level (point C) that is at or below the current market price (point A) in anticipation of a future price hike (CD). If the trader instead opens a market order at point A, then, provided there is no significant slippage, he is going to generate a profit as soon as the price starts to climb towards point B, and potentially F. However, the risk of using a market order under this particular scenario is encompassed by the possibility of the price falling towards point C, and even point E. Moreover, the market order does not offer much protection against adverse fluctuations (the price falling to point C before it eventually goes to D).

It can also be asserted that the limit order is going to yield higher profits compared to the market order (in the best-case scenarios for both), since CD>AF. If there is slippage on the market order, this difference will be even more pronounced.

The potentially negative outcomes that could be expected from trading with a limit order in this particular scenario are two. Firstly, if the price moves from points A to B, but then it does not reach C, the limit order will not be filled. Consequently, no profits will be generated, and the opportunity would be squandered. In this particular scenario, the trader would have been better off going for the market order, as he would have made profits equal to at least AB, potentially even AF. Secondly, if the price does fall to point C, but then it continues to depreciate towards E, it will immediately start generating losses. At least the limit order would incur lesser losses than the market order under these circumstances, as CE<AE.

This example, however, assumes some leeway in its projections of the likely future price action, as naturally, the best-case scenario would be for the price to immediately start depreciating from points A to C, so that the limit order can be filled at $30. The trader would then be hoping that the price would start climbing towards point D. In practice, he would not have to account for similar adverse price swings like the one between points A and B before his order can be filled at point C. Such a level of complexity is not necessary for real-life trading. However, it highlights the essential benefit of using limit orders – if used right, they can help the trader squeeze more profits from his trading than he would have otherwise done using simple market orders.